Trading Divergence Part 3 – Using RSI and Stochastic to Spot Divergence

The last 2 weeks we focused on finding divergence signals on the MACD, you can read about it here Part 1 and here Part2. But divergence can show up on other indicators too and we'll go over some of them here.

Let's start with the Relative Strength Index (RSI). We'll use the most common and usually default setting which is 14 period, applied to close. The RSI is measured on a fixed scale from 0 -100. The 70 and 30 lines you see on the chart below are used by some as overbought and oversold levels.

The creator of the RSI, J. Welles Wilder, thought that a divergence between the RSI and price action is a very strong indication that a market turning point is imminent. Like we mentioned in our previous articles, divergence happens when price moves up and makes a higher high but the indicator fails to make a new high and prints a lower high instead.

In our chart above, you can see the first example of an RSI divergence is a bullish divergence, when price makes a new low but the RSI prints a higher low, indicating a possible reversal. The EUR/USD pair rallied 116 pips from that point. We used a conservative entry in the example above, that is when we wait for the RSI to actually close upward and thus confirm the move up. The Stop Loss, just like with the MACD, is put just below the swing low and in the first example was only 10 pips.

The second example is of a bearish RSI divergence. Price makes a new high but the RSI makes a lower high. Stop Loss in this case would be just above the swing high at 1.2381, just 14 pips from our entry point. The EUR/USD fell 79 pips after the signal. Interesting thing to note is that on Friday, August 17, when this example is taken, an RSI divergence would get us in a divergence trade sooner then the MACD. Using a conservative entry for both indicators, the RSI printed a signal 1 hour sooner then the MACD. Compare this RSI divergence with the MACD example in my previous article. The graph is HERE for your convenience.

Another indicator wildly used for divergence purposes is the Stochastic Oscillator, commonly called the Stochastic or Stoch. Common settings for the Stoch are 8 for the K-period, 3 for the D-period and 3 for slowing/smoothing. For comparison purposes, we'll use the same 2 days , the 16th and 17th of August, as we did with the RSI and the MACD, just to get an idea of how the different indicators react at the same time.

In the chart above we can see that the Stoch signaled a divergence at the same time as the RSI, in the first example price moves lower but the Stoch prints higher and reverses for the second signal. Both the RSI and the Stoch would get us in sooner for the second signal on August 17 than the MACD. But in trading there is always a trade-off between getting in sooner versus waiting and you may end up paying for that earlier entry by getting in more bad trades in the future. Experiment with finding divergence signals on the RSI and the Stoch and maybe try out different settings to find out what works for you.